Last week the price of gold rose to $1,100, the highest ever
recorded. Gold is still an important measure of the world economy. The
theory of the 19th-century gold standard was that gold was “real money”
in the same way as landed property was “real estate”. All types of
paper money are capable of being created by banks or governments, so
the supply is potentially unlimited. It was observed that gold holds
its purchasing power over centuries, whereas paper money tends to
depreciate towards the value of zero.

Of course, the rise in the gold price reflects the weakness of the
dollar as well the strength of gold. I have been writing about the
significance of the gold price since the early 1970s. The latest rise
in price reflects the significance of gold as part of the world’s
monetary reserves.

The immediate cause of the rise was a purchase of 200 tonnes of gold
bullion by the Reserve Bank of India from the International Monetary
Fund. The Indian purchase is quite large in terms of the gold market,
but not particularly large in terms of the Indian reserves. India’s
reserves now amount to $277 billion, of which this new purchase of gold
amounts to only $6.7 billion.

The significance of the purchase is that it may be the start of a
new phase in the struggle between gold and paper. Since 1971, when
President Nixon ended the convertibility of the dollar into gold under
the Bretton Woods Agreement, the world’s central banks have tended to
be net sellers of gold and net buyers of dollars. Now the Indians have
decided that they have more dollars than they want.

Already Sri Lanka has followed the Indian lead, with a purchase of
five tonnes of gold. If the new fashion spreads, and particularly if it
is joined by China, then Asia would have decided that it is better to
have gold which is rising in value than an unlimited supply of dollars
which are falling in value.

In the 19th century, bankers trusted gold precisely because they did
not trust other bankers, or the paper that other bankers issued. They
could hold gold in their own vaults; it would not be dependent on other
people’s debts or on the printing of paper money. Most central bankers
still believe that the purchasing power of money is ultimately
determined by the quantity that is created.

Asian bankers know that the West, and particularly the US, has been
creating new money in huge and unprecedented quantities. They must
assume that this increase in the creation of dollars will result in a
fall in the purchasing power of the dollar itself. China may or may not
join in the movement to buy gold, but the logic of the market would
justify it doing so. Why should China go on losing in dollars when the
gold price is rising?

This new logic extends outside gold and outside currencies. The real
struggle between gold and paper is a struggle for power. If paper money
is the dominant form of currency, as it is at present, then the
ultimate governors of the world economic system are the bankers who
have the power to create money.

If, however, gold is regarded as the ultimate standard, as “real
money”, then the market decides the valuation. The floating rate system
which emerged after 1971 depends on relatively stable relationships
between different currencies. If countries develop a preference for
gold over paper, then paper currencies will have to demonstrate that
they have a stable value in gold, as they did in the years before 1971.

This may help to explain the strange events that occurred in the G20
finance meeting at St Andrews. In the 1970s, an American economist,
James Tobin saw very clearly the speculation that would arise after
Nixon ended the convertibility of the dollar into gold. Tobin, who
later won a Nobel Prize, knew that gold had been the standard by which
other currencies were valued. Once that was removed, he feared a growth
of excessive speculation, such as the inflation of the 1970s, or the
successive bubbles of recent years. He thought that this speculation
could be controlled if it were taxed. He advocated a new transaction
tax.

At St Andrews, Gordon Brown unexpectedly advocated the adoption of a
global Tobin tax. He was immediately repudiated by Timothy Geithner,
the US Treasury Secretary, and by Dominique Strauss-Kahn, the head of
the IMF. The proposed global Tobin tax has the support of Oxfam and of
some left-wing economists, but without American support, it does not
have the least chance of being adopted.

The Swedes experimented with a national transaction tax in the
1980s. It did not work because bankers avoided paying tax by
transferring transactions to markets in which it was not imposed. The
tax had to be abandoned in the early 1990s. This negative history must
have been known to Mr Brown; perhaps the clumsiness of his diplomacy
reflects the pressure he is feeling.

In Britain, there is an urgent need for a new tax base. One can take
almost any very large figure as the sum needed to balance the budget.
At some point, Britain will have to raise taxes and cut expenditure. It
is hard to see where this additional revenue can be found.

No doubt it would be helpful to Mr Brown if the other governments of
the world would join him in policing a worldwide transaction tax on the
banks. Britain would be a major beneficiary. Like the US, Britain has a
combination of very large bank debts with a very large budget deficit.
As a response to the recession, large sums of money have been injected
into these economies. That has eroded global confidence in the pound
and dollar.

If there is no Tobin tax, it will be difficult to rebuild confidence
in these currencies, and the Tobin tax is not going to happen, if only
because it would not work. Two factors emerge. Gold will be a stronger
reserve currency than paper, and the market will increasingly decide
national policies. “You can’t buck the market”, whether in taxes, in
dollars or in gold.